March 2002 Volume 83 Number 3 "serving the protectors"
Shares
By Ruth McCance, ASX Investor Education

Protecting your shares with options

Most readers will be familiar with shares as an investment, but may not have considered the opportunities provided by exchange traded options.

Options have been traded on ASX’s options market since 1976, and are increasingly used by investors to complement their share investments. While some private investors have the impression that options are only for sophisticated institutional investors, this is not so.

Increasing numbers of private investors are using options in a range of strategies. In fact, the last 12 months has seen an extraordinary increase in options trading, to the extent that the number of options contracts traded regularly matches the number of ordinary share transactions.

There are many possible option strategies, but one to look at is the use of put options to protect your shares.

Consider a situation where you are concerned about a possible fall in the value of one of your shareholdings. As a share investor, traditionally you have had two choices:

• Maintain your shareholding and ride out any downturn in the stock price; or

• Sell your shares before the downturn.

There are two main problems with the second alternative. First, your market view may turn out to be incorrect, and as a result you miss out on a continued rise in the stock price. Second, you may realize a capital gain by selling your shares, and incur a capital gains tax liability.

Put options enable you to protect the value of your shares without having to sell them, and without losing your exposure to a rise in the share price.

A put option gives you the right, but not the obligation, to sell shares at a specified price (the exercise price), on or before a specified date (the expiry).

For example, assume that on February 6, shares in MIM Ltd are trading at $1.40, having run up from around $1.10 over the last two months. You hold 10,000 shares, and are concerned that the share price may fall back over the next six weeks or so.

In this situation you could buy ten MIM March $1.40 put options. Each option gives you the right to sell 1,000 MIM shares for $1.40, at any time up until the expiry of the option on March 27. The price (premium) of this option on February 6 is $0.70, or $70 for each option contract. Your total outlay therefore is $700 (plus transaction costs) for 10 contracts, covering your 10,000 shares.

Let’s say that at expiry of the options the MIM share price has fallen to $1.10. You now have two choices:

• You can exercise your options and sell your MIM shares for $1.40; or

• You can sell your put option and retain your shares. Although the shares are now worth only $1.10, the options should be worth around $0.30 – the difference between the exercise price and the MIM share price.

The profit of $0.23 on your option trade largely offsets the unrealized loss of $0.30 on the shares.

If the share price at expiry is above $1.40, your options will expire worthless. However, your shares will have increased in value. You have not capped your potential profit on your shares during this period.

You can see this strategy as similar to taking out insurance over your car or house, and the cost of the options as similar to the insurance premium. You hope that your shares will continue to rise in value and you will not need “insurance”. However, if the share price does fall, you have the security of having locked in a minimum sale price for the life of the options. The most you can lose is the premium you paid for the options.

You are free to sell or exercise your options at any time before expiry.

There is a wide range of option strategies available, reflecting almost any view you might have on a particular stock, or on the market as a whole. Shares will, in future issues, cover option strategies that enable you to earn extra income, or gain leveraged exposure to share price movements.

Options are available over about 60 of the largest companies traded on ASX, as well as over the S&P/ASX 200 Index. For more information about options, go to www.asx.com.au/options or talk to your broker. ASX also runs courses on options – details are listed on the ASX website.

This article was written by the ASX Investor Education unit. It is not intended as investment advice or a recommendation of specific securities. For more information, phone the ASX on 1 300 300 279, or go to the ASX website, asx.com.au.

This article contains general information only. It is not intended as and must not be relied upon as investment advice. You should consult a licensed professional advisor prior to making any investment decision.

The information contained in this article is provided in good faith and derived from sources believed to be accurate as at the date of publication. However, no warranty of accuracy or reliability as to such information is given. Australian Stock Exchange Limited and its associated and related companies will not be liable for any loss or damage arising in any way from or in connection with anything provided in or omitted from this article or from any action taken or inaction in reliance on the article. This article does not contain an invitation or offer to invest in securities or other financial products and nothing in this article is to be taken as ASX endorsing promoting or expressing any opinion on any securities or other financial products.

©Australian Stock Exchange Limited ABN 98 008 624 691. All rights reserved.

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